One of the Commission's principal
responsibilities is to assure that futures markets operate competitively,
free of manipulation or congestion, and serve the risk-shifting and
price-discovery needs of the U.S. and world economies. Division of
Economic Analysis (DEA) programs - Market Surveillance, Market
Analysis, and Market Research - focus on these objectives. DEA
periodically examines the effectiveness of its programs and seeks to
institute revisions that reduce the costs of compliance. During FY 1999,
DEA proposed or implemented the following reforms.

Commission Guideline No. 1

On June 1, 1999, the Commission
published final rules revising its Guideline on Economic and Public
Interest Requirements for Contract Market Designation (Guideline No. 1).
Guideline No. 1 details the information that an application for contract
market designation should include in order to demonstrate that the
contract market meets the economic requirements for designation. The
revisions to Guideline No. 1 simplify the application for new contract
approval and eliminate unnecessary paperwork burdens associated with the
designation application itself.

The Commission organized Guideline No. 1
into several specific application forms, making use of a chart format for
applications for designation of futures and option contracts to the
extent possible. The Commission will now allow the use of
third-party-generated materials in support of an application. In
addition, the Commission clarified the review standards for several of
the designation requirements. The Commission added a new appendix to
Part 5 specifying the information that a foreign board of trade
should submit to the Commission when seeking no-action relief to offer
and to sell to persons located in the United States a futures contract or
a futures contract on a foreign securities index traded on that foreign
board of trade.

Approval Procedures for New Futures
Contracts

In addition to the changes to Guideline
No. 1, the Commission proposed a far-reaching and fundamental change to
its approval procedures for new futures contracts offered on U.S.
exchanges. This change responds to U.S. futures exchanges' concerns
that their ability to list new contracts without delay is important to
their continued competitiveness, particularly with foreign exchanges.
Specifically, the Commission proposed a two-year pilot program to permit
the listing of certain futures and option contracts on U.S. exchanges
prior to CFTC review and approval. The Commission proposed the rule under
the broad exemptive authority provided in section 4(c) of the Commodity
Exchange Act. As proposed, U.S. exchanges would retain the choice to
proceed under the current procedures for approval of new futures and
option contracts, including fast-track review procedures. The proposed
rule is pending further Commission consideration.

Contract Market Rule Review and Approval
Procedures

On July 15, 1999, the Commission published
proposed rules that would further streamline its procedures for reviewing
exchange rules. The CFTC proposed to allow additional categories of
exchange rule amendments to be approved automatically, upon adoption by
the exchange, and to permit such amendments to be submitted to the
Commission in a single, weekly, summary filing rather than in individual
submissions. For certain other rules, the review time would be reduced to
three days. The proposed rules also reorganize, in a clearer and more
accessible format, the Commission's rules on expedited approval
procedures for proposed rule amendments to contract terms and
conditions.

Speculative Position Limit Rules

On May 5, 1999, the Commission published
final rules increasing speculative position limits for various domestic
agricultural products and streamlined certain associated rules. These
rules limit the size of positions that speculators may hold in the U.S.
futures markets and have been a key regulatory feature for over 60
years.

The revisions increase Commission
speculative position limits only in the deferred trading months; the
number of positions speculators are permitted to hold in the spot month
remains unchanged. In addition, the revised rules simplify and reorganize
various associated policies, exemptions, and rules by incorporating them
in a single section of the Commission's rulebook. The rules also
include a new provision on the aggregation of accounts by exempt
commodity pools.

Fast-Track Procedures

FY 1999 was the second full year of
operation of the Commission's new fast-track review procedures, which
streamlined the contract market designation process. Of the 73 contracts
approved during FY 1999, 30 were submitted by the exchanges for
processing under the new procedures. Twenty-one were approved under
10-day fast-track provisions and nine were approved under 45-day
fast-track provisions.

Agricultural Trade Options

On August 31, 1999, the Commission
published proposed changes to its rules on agricultural trade options.
Agricultural trade options are off-exchange options on specified domestic
agricultural commodities offered to producers, processors, or
merchandisers in connection with their business. The Commission adopted
the current rules permitting the offer and sale of agricultural trade
options on April 16, 1998. These rules, among other things, require
merchants offering these options to register with the Commission, require
risk disclosure to customers, and place certain restrictions on the types
of options permitted.

In February 1999, the Commission released
two additional educational pamphlets on agricultural trade options
entitled "How to Become an Agricultural Trade Option Merchant"
and "Agricultural Trade Options - Information for Lenders and
Extension Agents," prepared by division staff. These brochures are
intended to complement a previously released Commission pamphlet entitled
"Agricultural Trade Options - What Agricultural Producers Need to
Know." These pamphlets provide an overview of agricultural trade
options and the rules for trading them.

The Commission has received a number of
comments from groups within the agricultural sector supporting
reconsideration of various aspects of the rules as a means of increasing
interest in the possible offer and sale of these instruments. After
reviewing carefully its current rules, the Commission proposed several
changes to permit greater flexibility in the types of options that can be
offered, to streamline the reporting and disclosure requirements, and to
bring the rules more into line with practices in the cash markets.

One notable change would permit cash
settlement of agricultural trade options. The proposal would also
streamline the registration requirements for agricultural trade option
merchants and their sales agents in several respects, including removing
the training requirement for sales agents. Proposed changes to the rules
would revise the required disclosure statements and reduce overall
reporting and recordkeeping requirements.

Market Analysis

The Market Analysis staff reviews
applications to trade futures or option contracts and all subsequent rule
changes on the terms and conditions of contracts that have economic
significance. Improperly designed contracts can increase the chance of
cash, futures, or option market disruptions and manipulation and
undermine the usefulness and efficiency of a market. To avoid these
consequences, the Market Analysis staff considers whether the terms and
conditions of a proposed contract or subsequent rule amendments to a
contract conform to commercial practice and provide for adequate
deliverable supplies. In the case of cash settlement contracts, staff
members evaluate the cash settlement procedure to assure that it will be
based on a reliable price series reflecting the underlying cash market.
The Market Analysis staff reviews a contract's potential commercial
usefulness for hedging and price basing, as well as other public interest
considerations.

New Futures and Option Contracts

During FY 1999, the staff completed
economic reviews of 38 applications for new futures contracts, 35
applications for new option contracts, and 135 rule amendment proposals
for existing futures and option contracts. Highlights of the new
contracts and rule amendments follow.

· Weather-Related Instruments.
The Commission approved the Chicago Mercantile Exchange (CME) degree days
index futures and option contracts, the first contracts based on weather
data. These contracts are based on indexes of accumulated temperature
variations, i.e., heating and cooling degree days, over a one-month
period for 10 specified cities in the United States - Atlanta, Georgia;
Chicago, Illinois; Cincinnati, Ohio; Dallas, Texas; Des Moines,
Iowa; Las Vegas, Nevada; New York, New York; Philadelphia, Pennsylvania;
Portland, Oregon; and Tucson, Arizona. These innovative contracts are
designed to provide a risk management tool to help businesses protect
their revenue during times of depressed demand or excessive costs due to
unexpected or unfavorable weather conditions.

· U.S. and Foreign Interest
Rates. The Commission approved several contracts based on U.S. and
foreign interest rates, including the flexible coupon U.S. Treasury bond
and Treasury note futures contracts of the Cantor Financial Futures
Exchange (CFFE) and the CME three-month Eurodollar FRA (forward rate
agreement) futures and option contracts. Contracts based on foreign
interest rates approved this fiscal year were the CME Euroyen LIBOR
(London Interbank Offered Rate) futures and option contracts. These
contracts are designed to provide a hedging vehicle for U.S. banks and
institutions that invest in U.S. or Japanese debt instruments or
otherwise have exposure to fluctuations in interest rates.

· Currency and Currency Cross
Rates. The Commission approved the MidAmerica Commodity Exchange euro
future; the New York Cotton Exchange (NYCE) small euro future; the NYCE
Australian dollar/Japanese yen cross rate, Australian dollar/New Zealand
dollar cross rate, Swiss franc/Japanese yen cross rate, euro/Canadian
dollar cross rate and euro/Norwegian krone cross rate futures and option
contracts; and the CME E-Mini Japanese yen and E-Mini euro futures and
option contracts. These contracts are designed to facilitate the
specialized hedging needs of import/export firms and institutional
investors having trade payments and receipts in these currencies. In the
normal course of conducting international trade, such firms face
significant exposure in these currencies that can be offset with
appropriately designed futures and option contracts.

· Regional Electricity
Contracts. Contracts approved by the Commission this fiscal year
include the New York Mercantile Exchange (NYMEX) and Chicago Board of
Trade (CBOT) PJM (Pennsylvania-New Jersey-Maryland) electricity futures
and option contracts. These contracts provide electricity market
participants risk management tools to respond to the evolving electricity
cash market in additional market regions of the eastern United States.
Regional differences exist in the supply and demand for electricity,
which result in pricing differences in the cash market. This is due to
regional variations in fuel sources used for generation, weather
conditions, and transmission costs, and, most importantly, limitations on
the available transmission capability between regions. These contracts
are designed to meet the special-ized hedging needs of firms in the
electricity industry as a result of the ongoing deregulation of that
industry.

· Aluminum. The Commission
approved the Commodity Exchange, Inc., aluminum contracts, which can be
used by firms in the aluminum industry to hedge price risks associated
with spot and forward market transactions in the U.S. aluminum cash
market.

Rule Changes

During FY 1999, the staff completed
economic reviews of 135 rule amendment packages for existing futures and
option contracts. Sixty-three of the rule changes were submitted for
review and approval under fast-track procedures. Of the 135 economic
reviews processed this fiscal year, 90% were completed within 45 days
(the fast-track review period), 79% were completed within 30 days, and
23% were completed within 10 days of submission.

Review of Delivery Specifications for
Wheat Futures Contract. During FY 1999, DEA reviewed and the
Commission approved amendments to the delivery specifications of the
CBOT's wheat futures contract that were submitted by the CBOT in
response to a request by the Commission. The Commission's request was
based on concerns about the heightened potential for price manipulation
due to the limited availability of deliverable supplies for the futures
contract. The amendments reduce the level of spot-month speculative
position limits applicable to the last five trading days of the March and
May contract months and change the locational price differentials for
deliveries at Toledo and St. Louis to make them more reflective of
cash-market pricing relationships among the contract's delivery
points.

In approving the amendments, the Commission
advised the CBOT of its continuing concerns about the adequacy of
deliverable supply of wheat during the months of March and May and recent
developments concerning increased concentration of ownership or control
of futures delivery facilities on the wheat futures contract. The CBOT
was, therefore, directed to report annually to the Commission, for five
years after contract expirations begin under the revised wheat contract
terms, on the experience with deliveries and expiration performance and
on the extent to which the contract's revised delivery terms may
discourage or encourage deliveries to be made. In addition, the
Commission directed the CBOT to monitor carefully the 1999 wheat, corn,
and soybean expirations to assess the degree of increased concentration
in the ownership and control of approved delivery facilities at the
contract's delivery points, to determine whether it impacts adversely
price convergence on the contracts, and to report its findings to the
Commission in January 2000.

Other significant rule changes approved
this year include:

· Changes to the delivery standards
for the CBOT medium-term U.S. Treasury note futures contract to reflect a
change in the U.S. Treasury pattern of auctioning five-year notes.

· Amendments to the CME Russian ruble
futures contract relating to the cash-settlement calculation procedures,
along with a proposal to reactivate trading in that contract.

· Revisions to the CBOT oat futures
contract to eliminate the 7.5-cent per bushel locational price discount
for deliveries at Minneapolis/St. Paul so that deliveries would be at par
with Chicago.

· Changes to the CBOT soybean oil
futures contract to revise automatic annual adjustments to locational
price differentials by raising to 20 cents from 10 cents per cwt the
maximum allowable change per territory; provide that warehouse operators
not on Class I railroads pay the switching/freight costs to the nearest
such railroad; and limit each regular facility's delivery capacity to
30 times its daily load-out rate.

· A proposal to reactivate trading in
the NYCE's dormant frozen concentrated orange juice #2 futures
contract and make substantive modifications to the contract's terms.
NYCE would change the quality standards by: adding a Brazil and Florida
origin requirement; revising the brix, score, flavor, and defects
standards; and adopting procedures for trading based on a price
differential relative to the existing frozen concentrated orange juice
contract up to the delivery month.

· Amendments submitted by the NYMEX to
the crude oil futures contract regarding deliverable foreign crudes and
the associated premiums and discounts for delivery of those
crudes.

· Revisions to the NYMEX's Palo
Verde and COB (California-Oregon-Border) electricity contracts to halve
the contract size and the rate of delivery, as well as changes to the
monthly delivery unit amounts.

· Changes to the CBOT U.S. Treasury
instrument futures contracts regarding the specified coupon for the
notional bond upon which the contracts are priced.

· Changes to the cash-settlement
calculation procedures for the CME cheddar cheese, stocker cattle, and
feeder cattle futures contracts to reflect changes to the manner in which
the U.S. Department of Agriculture calculates the component values of
those prices.

Market Surveillance

The Market Surveillance program is designed
to maintain free and competitive futures and option markets by protecting
the price discovery and risk transfer functions of those markets. Because
attempted manipulation and other abusive practices could undermine the
capacity of these markets to perform their economic functions, the Market
Surveillance program takes preventative measures to ensure that market
prices accurately reflect fundamental supply and demand conditions. Some
of these measures include the routine daily monitoring of large trader
positions, futures and cash prices, price relationships, and supply and
demand factors in order to detect any threats of price
manipulation.

The Market Surveillance staff works closely
with the exchanges and other government agencies to deal with any
potential market threats that may develop. The staff apprises the
Commissioners and senior CFTC staff of potential problems and significant
market developments at weekly surveillance briefings so that the
Commission is prepared to take prompt regulatory action when
warranted.

Financial Markets

During FY 1999, Market Surveillance staff
monitored closely the financial futures and cash markets as the domestic
equity indexes continued to rise at an extraordinary pace and experienced
periods of considerable price volatility. Early in FY 1999,
yields-to-maturity on U.S. Treasury instruments reached record lows, the
yield curve flattened, and the U.S. dollar continued to appreciate. This
rapid escalation of stock index values and volatility was accompanied by
historically high price/earnings ratios and low dividend yields. The
primary impetus behind this upsurge in equity values was a combination of
relatively moderate economic growth, low inflation and interest rates,
subdued wage pressures, an appreciating U.S. dollar, and the expectation
of improving labor productivity and corporate earnings. With returns on
money market and credit instruments at comparatively low levels, capital
flows poured into the equity sector, particularly into technology stocks.
Financial turmoil in Russia and Brazil, including the default on Russian
debt obligations, contributed significantly to the volatility experienced
in global financial markets during this period. Further losses were
caused by a mass liquidation and subsequent evaporation of liquidity in
global financial markets following the recapitalization of Long Term
Capital Management LP. Later in FY 1999, the U.S. dollar weakened
significantly relative to the Japanese yen and interest rates rose on
speculation of higher inflation and a tightening of monetary policy by
the Federal Reserve Board, an increasing trade deficit, and prospects for
a global economic recovery, although equity prices remained at high
levels. Staff conducted heightened surveillance and prepared special
analyses of these events and circuit breaker mechanisms. Staff also
shared information with other financial regulators.

Copper

Market Surveillance staff continued to
support the Commission's investigation of possible manipulation of
the copper market in relation to the activities of Sumitomo Corporation.
On May 20, 1999, the Commission filed a complaint charging Global
Minerals and Metals Corporation (Global) and two of its officers with
manipulating and cornering the copper market. The complaint also named
affiliates of Merrill Lynch Pierce Fenner and Smith with aiding and
abetting Global in the copper manipulation. In June 1999, the Commission
issued an order accepting an offer of settlement from Merrill (B&D)
and Merrill International and dismissing the proceedings as to Merrill
Lynch & Co., Inc.

Energy

Crude oil and petroleum product prices fell
sharply to 12-year lows in the fall of 1998. Rising global oil supplies,
particularly large oil stocks and high levels of production, outpaced
international consumption in the wake of reduced Asian and global demand.
NYMEX crude oil futures reached a low of $10.72 per barrel, down about
forty percent from the prior year. Later in FY 1999, prices increased
significantly on Organization of Petroleum Exporting Countries (OPEC)
supply restrictions and prospects for a global economic recovery.
Surveillance staff monitored the expiring energy futures expirations
during this period for indications of price manipulation.

Cattle

Market Surveillance staff intensified
monitoring of live cattle futures expirations, several of which were
characterized by a concentrated holding of long futures positions, a wide
premium of the futures price over the cash price of deliverable cattle at
the beginning of the delivery period, and subsequent heavy futures
deliveries. Staff made numerous contacts with large traders in these
futures contracts and with exchange surveillance staff. The basis
narrowed to normal levels as the last trading date approached and as
large traders liquidated their positions.

Cotton

The Market Surveillance staff monitored
closely the March 1999 cotton futures expiration. At the start of the
notice period, the settlement price of the March future rose sharply and
the spread between the March 1999 and May 1999 futures went from a
discount to a premium. A major cotton merchant had a large long position
and was taking deliveries to compensate for a severe shortage of good
quality cotton from certain growing regions. The Market Surveillance
staffs of both the Commission and the NYCE monitored this future closely
and were in regular communication with the long trader and other market
participants. The strong price of the March future and the tightening of
the March-May spread encouraged traders with short positions to make an
exceptionally large number of deliveries. The long trader stopped
notices, but also transacted exchanges of futures contracts for physicals
(EFPs) and sold or rolled over a significant portion of its position. The
March 1999 cotton future expired in an orderly manner.

Large Trader Reporting

Completion of the integrated surveillance
system, including the transition from mainframe to client-server
technology, is scheduled for FY 2000. The Commission's Market
Surveillance program relies heavily on an extensive automated large
trader reporting system that allows economists to analyze the futures
positions of all large traders on a daily basis. The new system
incorporates the daily option large trader data that is necessary for
effective surveillance. Most hardware, and much of the software,
necessary for collection of this additional data is in place and staff
have been collecting daily option large trader data using this system
since October 1997. Migration from the mainframe to client-server will
occur prior to January 2000. At that time, core programs for Market
Surveillance will be in place. Additional programming resources will be
required to add capabilities present in the mainframe system.

The new system has allowed the Commission
to build software to facilitate electronic reporting by firms that
formerly filed manual reports. Additionally, the Commission has relieved
a burden on the exchanges by no longer requiring them to file option
large trader data.

Market Research

The Market Research staff conducts research
on major policy issues facing the Commission; assesses the economic
impact of CFTC regulatory changes on the futures markets and other
sectors of the economy; participates in the development of Commission
rulemakings; provides expert economic support and advice to other
Commission divisions; and conducts special market studies and
evaluations.

During FY 1999, the Market Research staff
provided analytic support to several Commission enforcement efforts
involving the alleged sale of illegal off-exchange futures and options.
In addition, the staff testified in several cases requiring expert
information on the economic functions and uses of futures
contracts.

The Market Research staff continued to
provide economic input into the analysis of commodity exchange and
Commission regulatory initiatives. Market Research staff participated
actively in the development of policies concerning new derivatives
instruments and trading mechanisms in futures markets. Staff also
continued to undertake market microstructure analyses in connection with
the Commission's review of exchange audit trail efforts and dual
trading issues. Recently, staff began examining the market impact of the
existing and alternative execution procedures such as exchanges for
physicals and block trading. Market Research staff also applied the
concepts of behavioral finance to study floor traders on futures
exchanges.

During FY 1999, Market Research staff
examined economic issues relating to exchange-proposed amendments to
existing futures and option contracts and to applications for new futures
contracts. Staff conducted research on delivery movement in the Midwest
to support the Commission's review of the CBOT's wheat delivery
proposal. The Market Research staff updated a 1994 study of the global
competitiveness of U.S. futures markets. Staff members continue to
conduct research on alternative derivative risk measurements and
risk-based capital requirement procedures.